Predicting future exchange rate changes based on interest rates and holding-period returns differentials net of the forward risk premium effects

Abstract

One of the well-known puzzles in the empirical exchange rate literature is the forward premium anomaly; the interest rates differential between two countries predicts the opposite direction of their future exchange rate changes compared to the predictions of the uncovered interest rate parity (UIRP) under the rational expectations hypothesis (REH). In this paper, we show that the above puzzle can be attributed to the time-variation of the exchange rate risk premium (known as forward risk premium). This premium can also explain the failure of the holding-period returns differential to provide unbiased predictions of the future exchange rate changes. To control for the risk premium effects, in this paper we suggest a new forward premium regression framework adjusting the interest rates differential for these effects which are estimated by a two-country term structure model. We provide evidence that the suggested framework can predict the correct direction of the future exchange rate changes for a number of developed countries with liquid currencies. However, its predictive power is small due to excess volatility of the exchange rate changes.